Wednesday, December 10, 2008

On December 09, 2008, the Bank of Canada slashed the Bank Rate by 75 basis points to 1.5%; the lowest level in 50 years. View their press announcement here.

What prompted this action on the part of the BoC? To begin, it is no secret that the outlook for the world economy has deteriorated very rapidly in recent months. The U.S. is currently in a recession and, while Canada is not technically in a recession (contrary to the Bank's assertion), growth has slowed to virtually zero. The Bank of Canada, which takes a very conventional view of the way the economy operates, is cutting the Bank Rate in an attempt to help stimulate consumer and business spending; which it believes will blunt the full impact of the impending global recession.

What does the Bank of Canada's policy action imply for the average Canadian? At the end of the day, probably not very much. The first thing to keep in mind is that the BoC has only a very limited and indirect impact on the interest rates that consumers and businesses face in the credit market. The BoC determines what is called the Bank Rate; which in turn influences what is called the Overnight Rate. The Overnight Rate is the interest rate that chartered banks use when they borrow and lend cash between themselves to manage their settlement balances and cash reserves. Keep in mind that they cannot simply borrow money at the Bank Rate from the Bank of Canada and then lend it out, say, to finance your mortgage or some business venture.

As far as Canadian businesses and consumers are concerned, the Overnight Rate is relevant only to the extent that it influences the terms on which they can borrow or lend in the credit market. In normal times, there is typically a direct link between the Overnight Rate and the market interest rates that chartered banks charge their customers based on standard lending practices. For example, the Prime Rate--which is the interest rate that banks charge to their best customers--is usually determined by the Overnight Rate plus (say) two percent. Mortgage rates are typically set as the Prime Rate plus (say) two percent; and so on. In this manner, a cut in the Bank Rate typically manifests itself as a cut in all market interest rates; an effect that lowers the cost of borrowing.

However, in times of financial turmoil, the link between the Bank Rate and market interest rates becomes somewhat disconnected. When chartered banks lend out money, they also take into account the perceived creditworthiness of their customers. If they perceive greater risk in their clients (as they well should, in the current economic climate), they are not likely to lower the interest rate they charge across the board. Or, they may lower the Prime Rate, but reduce the number of clients who have access to Prime. Indeed, they may refuse to extend credit altogether; and there is very little that the Bank of Canada can do to influence the lending practices of the private sector.

The basic lesson is that the relevant interest rates are largely determined by the market; for example, the yields on 91 day treasuries was already well below the previous Bank Rate. To a large extent, the Bank of Canada can do little more than follow what the market dictates; the market wants lower interest rates on high grade government securities and the Bank is to a large extent simply accommodating this desire.

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